**1. Introduction**

In the current practice, Islamic banks (IBs) are subject to two internal mechanisms of CG: The Board of Directors (BoD) and the *Shari'ah* supervisory boards (SSBs). This extra layer of governance in the IBs, as represented by SSB, modifies their governance structure from a "single-layer" as in the conventional banks (CBs) into a "multi-layer" governance [1, 2]. Abdelsalam et al. [3] argue that this dual board structure strengthens both moral and legal accountabilities of IB management, and then, it may reduce these banks' risk. Therefore, the establishment of an SSB for IBs is essential [4]. For the IBs, in order to enhance their customers' trust, they must guarantee that all their products and operations are in compliance with the *Shari'ah* rules [5]. *Shari'ah* noncompliance can be a reason for reputational risk that can make the Islamic finance sector susceptible to instability and can trigger

bank failure as most of the customers prefer the IBs for religious reasons [6]. These risks also include higher costs, financial losses, liquidity problems, bank runs, bank failure, industry smearing and financial instability [6, 7].

especially after the financial crises, the Asian financial crisis of 1997 and the global financial crisis of 2008. According to [18], as the financial transactions in the Islamic system are trade and asset based, it is assumed that this system will be more resilient to the financial shocks. Despite this, there are many examples of Islamic financial institutions (IFIs) that suffer from poor CG especially during crisis periods. The fall of Ihlas Finance House of Turkey in 2001, South Africa's IB in 1997 and the Dubai Islamic IB's losses between 2004 and 2007 are the clearest evidences of the IFI's poor governance [9, 19]. Many scholars argue that poor CG of financial institutions is one of the main causes of the financial crisis of 2008 [20]. It is now widely acknowledged that shortcomings in bank CG may have had a central role in

*Relevance of* Shari'ah *Governance in Driving Performance of Islamic…*

The CG weaknesses and strengths are determined by many factors especially the CG mechanisms. Therefore, companies that have strong CG mechanisms tend to be more successful as compared to those companies having weak corporate mechanisms [22]. Accordingly, companies that have effective corporate boards during crisis periods are more likely to introduce turnaround plans [23]. As Abatecola et al. [24] assert, most of the empirical studies confirm that corporate board characteris-

Being considered that IBs are subject to two internal mechanisms of CG, the BoD

Few studies, however, have so far been focused on CG structure of IBs and link it to their performance during crisis such as the study of [15]. In this study, Mollah et al. [15] investigate whether the CG structure of IBs can help them in reducing the impact of the crisis of 2008. To do so, they examined the impact of the CG1 on performance of the IBs vs. CBs and found that the SSB size influences the IBs' performance positively during the crisis period. They argue that the SG diminishes the negative impact of excessive risk taking and then improves the IBs' performance [15]. However, Nomran and Haron [27] claim that the study of [15] suffers from some limitations such as it used the SSB size as a single proxy of SSB governance and neglected many important SSB characteristics that may affect the board performances. Thus, Nomran and Haron [27] overcome this limitation by using an SSB score that takes into consideration the impact of other important SSB characteristics. Similarly, the current study also uses this SSB score to measure SSB super-

Basically, IBs have unique framework against the backdrop of *Shari'ah* ruling that plays an important role in their resilience. The CG structure of IBs, which includes the SG, helps them undertake higher risks and decrease the effect of the crisis on their profitability [15]. Alman [28] asserts that taking the crisis period into

<sup>1</sup> BoD structure (board size and independence), CEO power (chair duality and internally recruited) and

and the SSB, it is paramount to provide insights on how SSB influences the IBs' performance during crisis periods. In general, most of the empirical studies in the literature have given attention to the BoD, while there is a lack of studies in the SSB context. As Nomran and Haron [26] argue, there is a need for more empirical studies to examine whether the effect of SSB on IB's performance differs during crisis periods, especially the financial crisis of 2008. They add that this would help IBs in developing their strategies to adopt an appropriate SSB structure that will

tics increase the survival probabilities of companies during crisis periods. Kowalewski [23] provides empirical evidence on how CG mechanisms operate differently in crisis and non-crisis periods. Adding to that, Srivastava [25] finds that BoD affects the company's performance, particularly during the period of

the development of the crisis [21].

*DOI: http://dx.doi.org/10.5772/intechopen.92368*

financial crisis.

SSB size.

**39**

sustain their performance.

vision as it will be shown in the methodology.

Providing an efficient *Shari'ah* supervision is crucial to the IBs for failing to do so may give negative impact on the Islamic finance industry as a whole; hence, the SSB has high responsibility and accountability in its role with regard to *Shari'ah* supervision. If IBs fail to ensure compliance with the *Shari'ah* rules, their position in the market will be negatively affected due to lack of customers' confidence [8, 9]. It is argued that one of the duties of SSB is to approve any new products before they go for full scale development, which in turn would decrease the risks of *Shari'ah* compatibility before developing the product [6]. New products will not be introduced to the customers before they are approved by the SSB [10]. Risks can arise when the product fails to meet market and customers' needs. Given the importance of SSBs for IBs, [11] claim that although some may compare SSB to BoD or to an investment committee, SSBs have more powers and rights. Thus, the roles and duties of SSB have no true equivalent in the West [11]. As such, [10] considers the SSBs as the substitute for the conventional BoD. Furthermore, the SSB is expected to advise the board, the management including the bank's subsidiaries and provide input to the bank on *Shari'ah* matters in order for the bank to comply with *Shari'ah* principles at all times [12].

The SSB plays an important role in determining the performance of IBs [4] and is responsible and accountable for all *Shari'ah* decisions, opinions and views provided by them to the IBs [12]. Given that SSB supervises bank investment, banks cannot invest beyond the SSB-approved investments even if they can earn a higher rate of returns [13]. The duties of the SSB include ensuring that the operations of the banks do not involve any dealings in prohibited industries [14]. Furthermore, the SSB has super authority to prevent the BoDs from charging interest (*riba*) payments and avoiding doubtful (*gharar*) investments in their products [15]. According to [6], the use of products that breach the *Shari'ah* principles is costly to the IBs in both the short run and the long run. In the short run, any revenue from the transactions that are not *Shari'ah* compliant is excluded from the income of the bank and donated to some charitable causes. Thus, *Shari'ah* noncompliance can affect the income and profitability of IBs adversely. In the long run, the dilution of *Shari'ah* principles can negatively affect the perception of stakeholders on the Islamic financial practice causing a serious loss of trust and credibility [6]. The nature of the SSBs' decision may influence the acceptance of one product over another; hence, the SSB approval could increase or decrease the volume of banking business [4], which may affect the bank's profitability [16]. The decision-making of the management in the IBs is indeed constrained by an SSB that rejects any proposals in light of *Shari'ah* principles [10].

The chapter is organized into four sections. The first section deals with the related literature and the hypotheses development. The second presents the data and methodology, while the third discusses the empirical result. The last section concludes the whole study.

#### **1.1 Internal corporate governance mechanisms and financial crisis of 2008**

In the current practices, CBs are not operating alone in the market as IBs have become their most competitive rival [17]. Many observers and industry players have shifted their interests toward the Islamic financial system as a viable alternative to the conventional one after the series of failures of several conventional financial institutions due to the crisis of 2008 [18]. Parallel with that attention, the importance of CG implementations has increased in the business environment

#### *Relevance of* Shari'ah *Governance in Driving Performance of Islamic… DOI: http://dx.doi.org/10.5772/intechopen.92368*

especially after the financial crises, the Asian financial crisis of 1997 and the global financial crisis of 2008. According to [18], as the financial transactions in the Islamic system are trade and asset based, it is assumed that this system will be more resilient to the financial shocks. Despite this, there are many examples of Islamic financial institutions (IFIs) that suffer from poor CG especially during crisis periods. The fall of Ihlas Finance House of Turkey in 2001, South Africa's IB in 1997 and the Dubai Islamic IB's losses between 2004 and 2007 are the clearest evidences of the IFI's poor governance [9, 19]. Many scholars argue that poor CG of financial institutions is one of the main causes of the financial crisis of 2008 [20]. It is now widely acknowledged that shortcomings in bank CG may have had a central role in the development of the crisis [21].

The CG weaknesses and strengths are determined by many factors especially the CG mechanisms. Therefore, companies that have strong CG mechanisms tend to be more successful as compared to those companies having weak corporate mechanisms [22]. Accordingly, companies that have effective corporate boards during crisis periods are more likely to introduce turnaround plans [23]. As Abatecola et al. [24] assert, most of the empirical studies confirm that corporate board characteristics increase the survival probabilities of companies during crisis periods. Kowalewski [23] provides empirical evidence on how CG mechanisms operate differently in crisis and non-crisis periods. Adding to that, Srivastava [25] finds that BoD affects the company's performance, particularly during the period of financial crisis.

Being considered that IBs are subject to two internal mechanisms of CG, the BoD and the SSB, it is paramount to provide insights on how SSB influences the IBs' performance during crisis periods. In general, most of the empirical studies in the literature have given attention to the BoD, while there is a lack of studies in the SSB context. As Nomran and Haron [26] argue, there is a need for more empirical studies to examine whether the effect of SSB on IB's performance differs during crisis periods, especially the financial crisis of 2008. They add that this would help IBs in developing their strategies to adopt an appropriate SSB structure that will sustain their performance.

Few studies, however, have so far been focused on CG structure of IBs and link it to their performance during crisis such as the study of [15]. In this study, Mollah et al. [15] investigate whether the CG structure of IBs can help them in reducing the impact of the crisis of 2008. To do so, they examined the impact of the CG1 on performance of the IBs vs. CBs and found that the SSB size influences the IBs' performance positively during the crisis period. They argue that the SG diminishes the negative impact of excessive risk taking and then improves the IBs' performance [15]. However, Nomran and Haron [27] claim that the study of [15] suffers from some limitations such as it used the SSB size as a single proxy of SSB governance and neglected many important SSB characteristics that may affect the board performances. Thus, Nomran and Haron [27] overcome this limitation by using an SSB score that takes into consideration the impact of other important SSB characteristics. Similarly, the current study also uses this SSB score to measure SSB supervision as it will be shown in the methodology.

Basically, IBs have unique framework against the backdrop of *Shari'ah* ruling that plays an important role in their resilience. The CG structure of IBs, which includes the SG, helps them undertake higher risks and decrease the effect of the crisis on their profitability [15]. Alman [28] asserts that taking the crisis period into

bank failure as most of the customers prefer the IBs for religious reasons [6]. These risks also include higher costs, financial losses, liquidity problems, bank runs, bank

Providing an efficient *Shari'ah* supervision is crucial to the IBs for failing to do so may give negative impact on the Islamic finance industry as a whole; hence, the SSB has high responsibility and accountability in its role with regard to *Shari'ah* supervision. If IBs fail to ensure compliance with the *Shari'ah* rules, their position in the market will be negatively affected due to lack of customers' confidence [8, 9]. It is argued that one of the duties of SSB is to approve any new products before they go for full scale development, which in turn would decrease the risks of *Shari'ah* compatibility before developing the product [6]. New products will not be introduced to the customers before they are approved by the SSB [10]. Risks can arise when the product fails to meet market and customers' needs. Given the importance of SSBs for IBs, [11] claim that although some may compare SSB to BoD or to an investment committee, SSBs have more powers and rights. Thus, the roles and duties of SSB have no true equivalent in the West [11]. As such, [10] considers the SSBs as the substitute for the conventional BoD. Furthermore, the SSB is expected to advise the board, the management including the bank's subsidiaries and provide input to the bank on *Shari'ah* matters in order for the bank to comply with *Shari'ah*

The SSB plays an important role in determining the performance of IBs [4] and is responsible and accountable for all *Shari'ah* decisions, opinions and views provided by them to the IBs [12]. Given that SSB supervises bank investment, banks cannot invest beyond the SSB-approved investments even if they can earn a higher rate of returns [13]. The duties of the SSB include ensuring that the operations of the banks do not involve any dealings in prohibited industries [14]. Furthermore, the SSB has super authority to prevent the BoDs from charging interest (*riba*) payments and avoiding doubtful (*gharar*) investments in their products [15]. According to [6], the use of products that breach the *Shari'ah* principles is costly to the IBs in both the short run and the long run. In the short run, any revenue from the transactions that are not *Shari'ah* compliant is excluded from the income of the bank and donated to some charitable causes. Thus, *Shari'ah* noncompliance can affect the income and profitability of IBs adversely. In the long run, the dilution of *Shari'ah* principles can negatively affect the perception of stakeholders on the Islamic financial practice causing a serious loss of trust and credibility [6]. The nature of the SSBs' decision may influence the acceptance of one product over another; hence, the SSB approval could increase or decrease the volume of banking business [4], which may affect the bank's profitability [16]. The decision-making of the management in the IBs is indeed constrained by an SSB that rejects any pro-

The chapter is organized into four sections. The first section deals with the related literature and the hypotheses development. The second presents the data and methodology, while the third discusses the empirical result. The last section

**1.1 Internal corporate governance mechanisms and financial crisis of 2008**

In the current practices, CBs are not operating alone in the market as IBs have become their most competitive rival [17]. Many observers and industry players have shifted their interests toward the Islamic financial system as a viable alternative to the conventional one after the series of failures of several conventional financial institutions due to the crisis of 2008 [18]. Parallel with that attention, the importance of CG implementations has increased in the business environment

failure, industry smearing and financial instability [6, 7].

principles at all times [12].

*Banking and Finance*

posals in light of *Shari'ah* principles [10].

concludes the whole study.

**38**

<sup>1</sup> BoD structure (board size and independence), CEO power (chair duality and internally recruited) and SSB size.

account while studying the impact of SSB is important. Thus, there is an open empirical research question as to whether the SSB supervision, as measured by an SSB score that takes into consideration the impact of the important SSB characteristics<sup>2</sup> , contributes to better performance of IBs during crisis periods.

capture the effect of the financial crisis of 2008; therefore, the study covers the period from 2007 to 2015, including crisis period (2007–2009) following the previous studies such as [36]. The data are merged from BankScope and World Bank country-level macroeconomic data with hand-collected data on SSB characteristics from annual reports of IBs for the sample period. The sample distribution is

In this study, the dependent variable, which is the performance of IBs, is mea-

The explanatory variables used are measured as the following. *Shari'ah* supervision is measured using SSB score [27]. The bank characteristics (size and age) and country-specific variables (GDP and inflation rate) that may affect performance are employed as control variables following previous research [15, 27]. **Table 2** provides a summary of the measurements of the dependent, control and explanatory vari-

This chapter employs the two-step system generalized method of moments (GMM). Studies on the relationships between CG and performance should control

*Three of the four IBs in Oman are windows, but they have separate financial statements (Sohar Islamic, Muzn Islamic*

**Country No of Islamic banks**

Algeria 1 Bahrain 9 Bangladesh 6 Bosnia 1 Brunei Darussalam 1 Indonesia 2 Jordan 3 Kuwait 2 Malaysia 11 Maldives 1 Oman 4 Pakistan 9 Qatar 3 Sudan 6 Syria 2 Thailand 1 United Kingdom 3 Yemen 1 Total 66

sured by ROA and ROE following the previous studies [15, 32].

*Relevance of* Shari'ah *Governance in Driving Performance of Islamic…*

*DOI: http://dx.doi.org/10.5772/intechopen.92368*

presented in **Table 1**.

**3.2 Measures of variables**

ables used in this study.

*& Meethaq Islamic).*

*Sample of the study.*

**Table 1.**

**41**

**3.3 Estimation method and model**
